Do CDS Spreads Reflect Credit Risks? Evidence from UK Bank Bailouts

Abstract

CDS spreads are believed to reflect credit risks but remained stable for major UK banks during the subprime crisis. To explain this gap, we employ probabilities of default (PD) from stock options. These may differ from those obtained from debt instruments but are useful for practical reasons and deliver meaningful results: bailed-out banks demonstrate a significant decrease in loss given default (LGD) embedded in their CDS spreads, unlike non-bailed-out banks and non-financials. Bailout announcements effectively counteract the LGD-PD co-movement suggested by the credit cycle view. A comparison is made with US banks where government　action appears less pronounced on LGD.

Keywords: Credit Default Swap (CDS), Loss Given Default (LGD), Volatility Surface

JEL Classification: C13, C52, G13